Obama to Cap Municipal Bond Tax Exemption?

When President Barack Obama unveils his budget for fiscal 2013 on Monday, many investors will be anxiously waiting to find out if the spending plan will affect the tax-exempt status of municipal bonds.

Their concerns center on a controversial measure that the president included in his American Jobs Act of 2011, which was unveiled in September. It called for a 28% cap to be placed on the amount of interest bond investors can deduct from their taxable incomes. Specifically, the measure would apply to so-called top earners, which are individuals who made $200,000 or more a year, and married couples filing jointly who made $250,000 or more a year.

The Obama administration, trying to get a handle on historic annual budget deficits due largely to the recession, has been in search of ways to raise revenues. By capping the amount of municipal bond interest that can be deducted from taxable income, the government could rake in more income tax revenues.

For more than a month, rumors have run rampant that the president would include the measure in his fiscal 2013 budget proposal, even though he was unable to get enough support for it to be passed last year. The idea that the president could reintroduce it has raised the ire of market players who see the measure as being a huge blow to municipal bond buyers.

One of the main reasons tax-exempt munis appeal to fixed-income investors is due to the tax savings they can reap. Bond investors receive principle and interest payments, usually twice a year, from the issuer of the bonds. The payments amount to income, and for the past 100 years, investors have been able to exclude the payments from their taxable income.

For investors who have high income tax rates, such as those in the 25% or higher federal income tax bracket, municipal bonds are even more attractive. Investors that fall in the top earners category are even more willing to accept the lower yields that go along with tax-exempt municipal bonds in exchange for the tax savings advantages.

Investors may pare back their municipal bond holdings so that their remaining municipal and state interest income would be tax-shielded, said Jeff Born, a finance professor and co-director of the MBA Program at Northeastern University in Boston. He added that a cap could lead to a decline in municipal bond prices.

“The ratio of municipal and state bond yields to fully-taxable yields suggests that at the margin most of the buyers are in the highest tax bracket,” Born said. “Thus, any loss of deductibility would expose most of the buyers to a big increase in taxes on that now taxable income, so these investors are almost certain to act and not ignore it like a rounding error.”

Because interest income earned by the bond purchaser is exempt from state and local taxes, issuers can pass savings to the investor in the form of lower interest rates. So reducing the amount of municipal bond interest that top earners can exclude could also
reduce the demand for municipal bonds.

If the cap is reintroduced on Monday, or if any subsequent proposals come up, their legality will likely be challenged. No matter, the effects would include turmoil in the tax-free bond market, according to Born.

State and local governments benefit hugely from being able to issue tax-exempt bonds. Their borrowing costs are lower because of the lower interest rates they have to pay on the bonds. Bond issuers will likely see their issuance costs rise as a direct result of having to pay higher interest rates.

“Since many states and municipalities are experiencing budget deficits of their own, this increase in borrowing cost would either make their deficits worse or they would have to cut back on other expenditures in order to pay the higher borrowing costs,” Born said. “Either way, the burden of this change would fall mainly on these units and those who consume services provided by these units.”

“While this looks like a ‘rich person’ issue, cutbacks in state and municipal services impact those who are not rich too,” Born said.